IRS Notice 2009-68 and Conversion of 401k With After Tax $
O.K. I thought this would be simple, but after reading an article yesterday, I am a little confused.
Here is the scenario. I have a client with about $300,000 in a 401(k) that she wants to convert. That $300,000 includes approximately $50,000 of after-tax dollars. We planned on rolling $250,000 directly to a new Roth IRA and having the $50,000 go directly to her. The 401k custodian has agreed to mail her two separate checks — one for $250,000 made payable to her new Roth IRA and one for $50,000 made payable to her.
After reading an article yesterday which references IRS Notice 2009-68, I think doing the above may create problem. The article contains the following quote:
“If you do a direct rollover of only a portion of the amount paid from the Plan and a portion is paid to you, each of the payments will include an allocable portion of the aftertax contributions.”
It seems as though we can not accomplish the goal of funding the Roth IRA with the pretax dollars and getting my client a check for the after tax dollars she contributed. The 401k we are talking about is one she has from a previous employer. She is 51 years old and is working for a new company now.
Any insight would be greatly appreciated. Thank you.
Permalink Submitted by Alan Spross on Thu, 2010-02-18 19:42
You are correct, this issue is strictly in limbo, as attested by the endless discussions on how to do this. Qualified plan administrators are all over the place on this issue thanks to lack of clarity from the IRS. No telling what the 1099R forms issued last month look like.
There is a way to accomplish this however, but it requires an indirect rollover to the employee. The major problem with that is the 20% mandatory withholding on the pre tax portion. Does the client have $50,000 to replace the withheld amount, or perhaps a lower amount for a partial distribution? If the client can replace the withholding and complete 60 day rollovers, the after tax amount can be limited to the Roth IRA. The pre tax rollover to the TIRA must be done first, and then the after tax amount to the Roth IRA.
There is no debate about this method since it is covered by Code Sec 402(c)2. But doing this with direct rollovers that avoid withholding is not likely to work because of the pro rate rules. Doing an indirect rollover overrides the pro rate rules per the above Code section.
Client could adjust other withholding downward to partially recover the withholding, but otherwise the IRS will have the mandatory withholding for over a year now. If she waited to December to do the distribution, that time could be cut down to 3 months.
Permalink Submitted by Edward Collins on Thu, 2010-02-18 20:03
Interesting. However, she does not intend to have the after tax dollars contributed to the Roth IRA. She wants that money directly. She will have the pretax converted to the Roth IRA. This whole situation seems ridiculous. I do not understand why the IRS is making this so difficult. I thought PPA was designed to simplify things.
Permalink Submitted by Alan Spross on Thu, 2010-02-18 20:36
It seems like none of the major tax provisions simplify anything. The rules just become more complex and the tax code longer every year. The pro rating of pre tax and after tax amounts seems to apply just as much to this situation as the one where the amounts are bound strictly for TIRA and Roth IRA rollovers.
However, I am not sure what she wants accomplished here. The pre tax conversion to the Roth IRA will produce a hefty tax bill. Does she plan to report the conversion in 2011 and 2012, and is the 50k for eventually paying the conversion taxes or for something else?
Permalink Submitted by Edward Collins on Fri, 2010-02-19 12:53
Yes. Her intent is to use the after tax contribution dollars to offset some of the income tax liability from the conversion of the pretax amount. She may defer the taxes over the 2011 and 2012 tax years but that has not been decided as of yet. I am not sure why this can not be done. It seems so simple. But I should know better than to try and apply reason and logic to tax policy.
Permalink Submitted by Mark Shvartsman on Sat, 2010-02-20 16:27
Hello,
Here is my scenario. I took 401K money from my former employer and rolled it over to the qualified IRA with the financial institution. I have received a 1099-R form that states (in box #1) about $170K of gross distribution and (in box #5) about $10K in after-tax contribution (employee contribution and etc). What should I do with this $10K money? What is the best way to deal with this $10K after-tax money? Should I request a check on this amount? If so, how should this to be reported in my tax return? Or should I just leave it with the rest of all the IRA money? Please help.
Thanks
Permalink Submitted by Alan Spross on Sat, 2010-02-20 19:39
Since you have added 10k in after tax funds to your IRA, they are now commingled with all that pre tax money in the IRA, and cannot come out separately. You need to document your IRA file that the next time you take a distribution or make a regular non deductible contribution, to complete Form 8606 to report the added basis in your IRA. That will prevent you from being taxed twice on that 10k.
For reporting your 1099R on the 2009 return, your return should show 170k on line 16a with -0- on 16b and “rollover” entered next to 16b. There will be no tax liability. But it is vital not to forget to file the 8606 at the proper time. You could file it with your current return if you are afraid you might forget it later. I think the IRS made an error when they changed their instructions, since they used to request the form for the year of the rollover, and I think there would be fewer errors if they went back to that recommendation.
Just so you understand how this would work, if your total IRA balance reaches 200k at some point in the future and you take a distribution, 10k is 5% of 200k, therefore whatever distribution you took out would be 5% tax free and 95% taxable. This is also true if you convert to a Roth IRA, ie 95% would be taxable.
Permalink Submitted by Jim Smith on Mon, 2010-02-22 14:10
I have a 401(k) with both pre-tax money and after-tax money. I guess I am not sure why I can’t just move the pre-tax money to my IRA (direct transfer) and then have them send me a check for the after tax money which I could then place into my Roth IRA? I don’t understand what the issue will be with my 1099R (will I have two of them?). My co-workers have have always rolled out the after-tax portion in the past and I don’t ever remember there being a problem…what is wrong with this strategy?